Tuesday, November 30, 2004

Commodities bull II: An oncoming train

I promised in a previous post, Commodities bull a bear for the environment, that I would discuss why no one, neither politicians nor corporations, can do anything in the short run to stop the current bull market in commodities.

To understand this it is useful to go back to the end of the last bull market and see why it ended. By the early '80s the prices of most basic commodities had crashed. The reason: high prices had led to vastly expanded exploration for and discovery of minerals and vastly expanded planting of food and fiber crops worldwide. These actions increased supply beyond what the market needed and led to surpluses. Hence, the prices of many commodities plummetted.

But the pain in the resource sector continued long after the top in prices was in. Since it takes up to a decade to find and develop a mine, for example, investments already in progress when the bull market ended continued. Of course, at the time, no one knew that the bull market had ended. People had been conditioned to believe that every pullback would be followed by even higher prices. (It was very much like what happened in technology stocks in the late '90s.) So, investment continued to flow into the resources sector causing a further increase in the supply of basic commodities.

Another example: While farmers' decisions about growing many crops can change from year to year depending on market conditions, some agricultural products require a multi-year commitment. Coffee trees take three or four years to bear fruit. That means a commitment to increase coffee plantings made at the top of the bull market might not have any effect until four years later when the new supply would enter an already glutted market.

In this way a bear market in commodities tends to feed on itself as continued hope for higher prices pushes up supply and plans made long ago come to fruition in a period when inventories of raw commodities are already swelling.

Eventually, after many years--sometimes a decade after the top--companies, investors and farmers lose heart. Gradually, they slow their search for minerals which have now become far less profitable in the wake of large surpluses. They may pull up unprofitable coffee trees and plant something else in hopes of making a better profit. In the end, a final wave of smart, productive people leave the resource sector: farmers retire and sell their land for development; even worse, many farmers simply lose their farms as the debt they built up while expanding crushes them; unprofitable mines close; mining geologists leave the field and few train to enter it; mining engineers find work elsewhere; marketing executives move away from the agricultural marketing, and so on. The best and the brightest MBAs have long since abandoned their jobs in the commodity futures pits and in the offices of grain merchants and bullion dealers and taken up residence on Wall Street to trade stocks and bonds.

What happens next? With fewer crops being grown and fewer minerals being found even as demand grows, shortages eventually appear. Prices rise, mildly at first, and then more swiftly as perceived shortages lead to the hoarding of materials essential to keep factories going. (In the past couple of years the entry of the Chinese into world commodity markets to get materials to expand their factories and keep them going has already created some parabolic moves in certain key commodity prices.)

With few new mines opening up and little exploration occurring, the next several years are marked by higher and higher prices for all things taken from beneath the earth. The booming mining industry now starts to look in earnest for new supplies at a furious rate. But, the long lag times between exploration and discovery and between discovery and development mean those supplies won't be forthcoming in any quantity for years. The same is true in the farm fields and orchards which are also expanding. Surplus stores of grain have been whittled down as demand has risen. Basic crop prices rise and farming becomes a superbly profitable line of work. Certain crops that require multi-year commitments such as coffee are planted again in hopes of reaping lucrative returns in an undersupplied market. And, there is a shortage of mining and oil drilling equipment and expertise. The now much-in-demand expertise departed long ago when times were bad. Profits rise; salaries inflate; investors pour money into new mines and resource-related industries; and the cycle begins its inexorable move toward a crest.

These dynamics are developing before our eyes. Because of the long lead times needed to develop new supply for many resources, nothing done today will have much effect on prices or supply for several years to come. Any proposed actions which are touted as providing quick results should be treated with skepticism. Actions such as opening public lands, sometimes protected lands, to private exploration will be done in the name of alleviating shortages; but this will often be done with an eye toward rewarding political contributors.

Sadly, such shortsighted moves will do nothing to address the profoundly serious resource issues we face in the areas of energy, water, soil and climate. When prices are low, few people worry about natural resources. When prices are high, all people want is to have more of what is scarce right away. To rely on the highs and the lows of the commodity cycle to guide us in making intelligent choices in the area of resources is the height of folly. We need a deeper and less financially driven context in which to consider critical natural resource issues.

(Comments are open to all. See my list of environmental blogs on my sidebar.)